Economics, public policy, monetary policy, financial regulation, with a New Zealand perspective

Deposit insurance, OBR etc

This wasn’t going to be the topic of today’s post, but I see Stuff has a story up based largely on a conversation I had late last week with their journalist Rob Stock. (NB In the first version I saw a couple of hours ago a rather important ‘not” was omitted from this sentence “But a big bank failure was imminent, he said”).

New Zealand is being tipped to join the rest of the OECD in having a government-backed bank deposit guarantee scheme.

Under the Reserve Bank’s Open Bank Resolution scheme (OBR), depositors at a failing bank might have to take a “haircut” with some of their money being taken to recapitalise their bank, and get it open for business again quickly.

But former Reserve Bank head of financial markets Michael Reddell is tipping an end for OBR following the release of a discussion paper into the future of the Reserve Bank.

The background to this was the release last week of a joint Reserve Bank/Treasury consultative document as part of phase 2 of the review of the Reserve Bank Act. I haven’t yet read the whole document, although a reader who has tells me it is a fairly substantive (and thus welcome) piece. But when Rob Stock got in touch to suggest he would like to talk about the reappearance of the OBR (Open Bank Resolution), I read the relevant section (chapter 4) on “Should there be depositor protection in New Zealand?”

Stock is not a fan of the OBR option and was uneasy as to why it was appearing in the consultative document. My response was along the lines that OBR had played a key role in Reserve Bank thinking about failure management for almost 20 years now. Any new consultative document (especially a joint RB/Treasury effort) had to build from where policy/rhetoric had been but that, nonetheless, my read of the document suggested a clear framing pointing towards (officials favouring) New Zealand adopting deposit insurance.

Treasury has favoured such a change for some years, while the Reserve Bank had historically been quite resistant – mostly, on my reading, because they take a rather naive wishful-thinking approach which ignores twin realpolitik pressures that ministers will face if a major bank is at the point of failure. They believe in the value of market discipline (as, surely, in some sense most people do) and don’t want to do anything that might acknowledge that it isn’t always going to be a feasible (political) option. In my view, in reaching for something nearer a first-best model in an idealised world, they increase the chances of third or fourth best outcomes. A well-run deposit insurance scheme isn’t perfect, but offers the prospect of a decent second-best set of outcomes. And, for what it is worth, would bring New Zealand into line with the rest of the advanced world. As the consultative document makes clear, of the OECD countries only New Zealand and Israel don’t have deposit insurance, and Israel has already indicated that it is going to introduce a scheme.

As I noted, it was hard to see why any of the parties in the current government would be resistant to introducing deposit insurance (the Greens had been openly calling for such a reform) and there had been signs that although the “old guard” of the Reserve Bank had been resistant to deposit insurance the new Governor was likely to be more receptive. (And in the off-the-record speech Orr gave a few months ago, it was reported that among his comments was “deposit insurance is coming”.) National had been resistant, but relevant context for that included the way they were landed with the aftermath – and losses – of the retail deposit guarantee scheme after coming into government late in 2008. The retail deposit guarantee scheme bore almost no relationship to a proper deposit insurance scheme – being introduced at the height of a crisis, primarily covering unsupervised institutions and then knowingly undercharging those institutions for the risk being assumed. But it is relevant (together with National’s bailout of AMI) in revealing how politicians are likely to behave under pressure in a financial crisis.

Why do I favour deposit insurance (as a second best)? I’ve covered this ground in other posts, but just briefly again. I see little or no prospect that, in event of the failure of a major bank, politicians will let retail depositors lose their money (reliance on OBR assumes exactly the opposite interpretation). If so, it is better to force depositors themselves to pay for that protection up-front, in the form of a modest annual insurance premium.

At present, with the four biggest banks all being subsidiaries of Australian bank parents, the failure of a major domestic bank is only seriously likely to occur if the parent is also in serious trouble. (And the 5th biggest bank is government owned – enough said really.) If the parent isn’t in serious trouble, there would be a strong expectation that the parent would recapitalise any troubled subsidiary and/or perhaps manage a gradual exit from the New Zealand market.

It simply isn’t very credible to suppose that if the ANZ banking group is failing, and the New Zealand subsidiary is also in serious trouble, a New Zealand government will let New Zealand depositors of ANZ lose (perhaps lots of) money while their Australian cousins and siblings (often literally given the size of the diaspora), depositors with the ANZ, are bailed out by (or covered by deposit protection by) the Australian government. It isn’t as if there is any very credible scenario in which the New Zealand government’s debt position had got so bad that the government could claim “we’d like to help, but just can’t”, and the optics (and substance) would be doubly difficult because it is generally recognised that a concomitant to making OBR work would probably be to extend guarantees to the liabilities of other (non-failing) banks – otherwise, in an atmosphere of crisis transferring funds to the failing bank will look very attractive to many.

My view on this is reinforced by the practical examples of bailouts we’ve seen. Sure, the previous Labour government let many small finance companies fail without intervening, but then the deposit guarantee scheme happened. AMI policyholders were bailed out, when there was no good public policy grounds (other than the politics of redistribution etc) for doing so. And, beyond banking, we had the bail-out of Air New Zealand in 2001. In the account of that episode that Alan Bollard (then Secretary to the Treasury) told, uncertainty about what might happen in the wake of any failure was a big part of the then Prime Minister’s decision. It would be the same with the failure of any systemic bank. It isn’t an ideal response, but it is an understandable one, and one has to build institutions around the limitations and constraints of democratic politics.

(The other reason why OBR is never likely to be used for big banks, is that in any failure of a major bank, trans-Tasman politics is likely to be to the fore, with a great deal of pressure from Australia for the failure of the bank group’s operations on both sides of the Tasman to be handled together/similarly. It was a little curious that nothing of this was mentioned in the chapter of the consultative document.)

If there is no established depositor protection mechanism and if politicians blanch at the point of failure – as almost inevitably they will – then in practice what is most likely to happen is that everyone will be bailed out. And that really would be quite unfortunate – big wholesale creditors, who really should be on their own (and able to manage risk in diversified portfolios), losing along with granny. And so one argument is that deposit insurance allows us to ring-fence and protect (and charge for the insurance upfront) retail depositors, while leaving wholesale creditors to their own devices in the event of failure. In other words, a proper deposit insurance scheme could increase the chances that OBR can actually be used to haircut the sort of people (funders) that most agree should lose in the event of a bank failure.

There were a few things in the Stock article where I’m quoted in a way that at least somewhat misrepresents what I said.

Reddell said he expected the deposit insurance to win out and the scheme to be run by the Government.

An EQC-like fund would be created to collect insurance premiums from all depositors, with no banks allowed to opt out, he said.

The question here had been about which private insurer would be strong enough to provide the deposit insurance. My response was that it was most unlikely such a scheme would be run through a private insurer – they too can become stressed in serious crises – and that what one would expect would be a government-run and underwritten fund, accumulating levies over the decades, and helping to cover any losses in the event of a major failure.

The premium would be about 10 basis points on deposits, so a deposit account paying interest of 3 per cent, would be cut to 2.9 per cent, with the rest funding the deposit guarantee premiums, Reddell said.

Here the question was mostly about who would bear the cost of the insurance. My point was that one would expect the cost to fall primarily on depositors (rather than say, borrowers or shareholders). The size of any premium (which should be differentiated by the riskiness of the institution) would be a matter to be determined, and varied over time, but I did note to Stock that for an AA rated bank that cost might be quite modest. I noted that although CDS (credit default swap) premia had increased since, in the half decade or so leading up to the 2008 financial crisis the premia for Australasian banks had typically been only around 10 basis points.

In other guarantee schemes each depositor only has a maximum amount of their money guaranteed. The paper mentions $50,000, but Reddell said the scheme, if introduced, would have a cap of around $100,000.

My point was that a cap of only $50000 (an idea mooted in the paper) didn’t seem particularly credible, and based on the levels of coverage in many overseas schemes (and under the deposit guarantee scheme) I would expect any deposit insurance scheme cap to be at least $100000. Set the cap too low and it will end up being unilaterally changed at the point of crisis, with no compensating revenue to cover the additional insurance being granted.

And finally

But a big bank failure was not imminent, he said.

“Canada has gone over 100 years without a big bank failure. There’s no reason to think we will get one in the next few decades,” he said.

Of course, failures are always possible, but much of the mindset and literature is too influenced by either US examples (where the state has had far too big a role in banking), or those from emerging markets. Canada provides a very striking contrast, but even in New Zealand or Australia the only period of systemic stress in the 20th century was in the period (the late 1980s) when a previously over-regulated system was deregulated quite quickly and everyone (lenders, borrowers, regulators) struggled to get to grips with applying sound banking practices in an unfamiliar environment. A once in a hundred year systemic bank failure is something authorities have to plan for, and given the choice between collecting modest annual insurance premia for a hundred years to cover some (or even all) of the cost of bailing out retail depositors, and doing nothing and (most probably) bailing them out anyway, I know which second-best alternative I’d choose.

I hope the government agrees, and acts to implement a deposit insurance regime for New Zealand. There are lots of operational details to work out if they do, and those aren’t the focus of this consultation document, but deposit insurance is the way we should be heading.

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34 thoughts on “Deposit insurance, OBR etc”

The ANZ savings account I have, called an on-line account, only pays 0.1% interest. So not much scope there. The ANZ also charges nearly 20% for an overdraft, and more for the credit card. I would have thought that that colossal margin would be more of an issue. It might even be usury, and old-fashioned term I know.

If the banks failed what gives money value anyway? I had a read of the official obr page on rbnz site and it explained it very well but finished with the sentence…Or the govt may chose to recapitalize the bank.

If one bank failed all the others may not. But a massive housing collapse would bring down everyone as currency would have zero value. All the money you saved under the bed would have no value like venezuela.

Why do people compare currency to being Paid in food or water as if it has a store of value.

International currency traders give the NZD value. A housing collapse would not bring down everyone as 40% of houses in NZ has no debt. 60% of houses are owner occupied and property investors debt is mostly paid for by tenants. House value collapse has got nothing to do with a banks balance sheet. It is borrowers debt which sits on a banks balance sheet. As long as borrowers can meet their monthly repayments the asset is performing and has a value based on future cashflow which can be discounted to todays dollars. Banks get worried when there are substantial job losses which impair loan repayments and as a result loan defaults impair a banks net asset position.

Surely the reserve bank can just purchase the troubled assets with a tap of the keyboard? Why should depositors have to give up their money (mine earns zero interest I believe in my current account) to an insurance scheme when we all know that taxpayers don’t need to fund a bank bailout? The banks can just sell their non-performing loans to the reserve bank for reserves…how about all those mortgage backed securities back in 2008? Isn’t this most likely what would happen anyway? There would be runs on all the banks if one big one was allowed to fail and people lost anything over 100K.

If the issue is just liquidity, you are right that the Bank can provide that easily. But the issue here is more about solvency. if the banks’ assets aren’t worth what they were supposed to be because borrowers are defaulting then the RB won’t pay more than market price for the assets.

On your final sentence, yes I think that is quite possible. As I noted in the post, if OBR is applied to one big bank, the liabilities of the other big banks will probably end up having to be guaranteed. Again, deposit insurance isn’t ideal, but it does seem less worse than many of the alternatives.

But surely that is just an artificial constraint? The TARP programme bought troubled assets in the US at a higher price than their “fair value”. I know TARP came from the Treasury but there is nothing stopping a government telling the Reserve Bank to buy troubled assets if it wants it to. It can pass relevant legislation if it wants or if that were needed. I can’t see that as a real constraint when the proverbial hits the fan. At the end of the day, the losses of a too big to fail bank will be “socialised”. That is what happens. Which raises the question of whether banks really are independent businesses.

There seems to be this strange banana republic idea that the RB would just tap a keyboard and money appears out of thin air. The RB runs a balance sheet which means the books have to balance. If the RB buys a troubled bank then it needs funds from the tax payer or it borrows from some international bank like the International Monetary Fund.

QE was funded by issuing trillions of dollars of US treasury bonds and then pumping the equivalent US cash into the local US economy. The are always 2 sides to balancing the books otherwise you end up a banana republic. The US could do that because many countries hold their currencies to a USD peg especially so with China at the time, which did buy trillions of US Treasury bonds helping to fund the US consumers appetite for Chinese manufactured product.

So Greatgreatstuff, you are saying that the US treasury issued more bonds and borrowed pre-existing money off holders of US dollars (foreign and resident) and then gave that money to the Fed who then used it to buy the mortgage backed securities and bonds from the financial institutions?

So how do you explain the massive increase in base money in the US – i.e. bank reserves? If it had come from pre-existing money that couldn’t have happened.

That base money was created out of thin air by the Fed. I think it is generally understood that QE is an asset swap – fed prints base money and buys bonds and securities. It doesn’t ‘borrow’ the money from anyone to buy those assets it just creates it.

The securities and bonds become the “asset” on the fed’s balance sheet and the base money the liability. The books balanced – but reserve banks did the “banana republic” thing – which turned out to cause pretty much no inflation…..perhaps prevent deflation a bit – jury is out….

Now that will most likely be done in NZ too if banks start failing when people can’t pay their mortgages.

“US Treasury bonds are a liability. Not an asset. US cash is an asset. Both were issued at the same time to Balance the books. If you don’t balance the books you are a banana republic.”

US Treasuries are a liability of the US government and an asset of the private sector.
US cash is a liability of the Federal Reserve and an asset of the private sector.

You could say both are liabilities of the US government as the Fed is essentially a creature of government. One earns interest the other doesn’t.

Are you saying that the Bank of England, the Fed and the ECB are all institutions of a “banana republic?” Perhaps that would be true if we’d seen hyperinflation.

I am confused as to your accounting for QE. When the Fed bought US treasuries as part of QE they became an asset on its balance sheet. Ditto the MBS. Offset by liabilities – new reserves. The books balanced.

Example, say a private institute received $10,000 savings deposit. The transactions could be, 10% of every savings deposit is held at the US Federal Bank in a Reserve Bank Fund. 90% is invested to generate a return.

As you can see from the transactions, there is no actual printing of more cash. The Reserve Bank fund has increased to buy Private Institute US Treasury Bonds. The cash already placed with the US Federal Reserve gets released replaced by the US Treasury Bond as only 10% Is required. It is effectively a early release of the US Treasury bond. The books balanced avoids a banana republic. You might notice there is a spare $1000 floating around because the value of the bond is more cash released bur don’t forget backed by the bond.

The RBNZ does not hold a 10% Bank Reserve Fund like the Federal Reserve does. The asset swap releases the 10% cash that the Federal Reserve holds from all banks. But the amount released has to be very carefully managed. Thats why there is QE, QE2 and QE3. Remember the spare $1000 floating around where the bond value exchanged creates a Bank Reserve Fund higher than the 10% cash released. This is where extreme care would have been taken to not panic investors in the USD.

The QE strategy that the US employed was clever in that they know that many countries held a USD peg to sell their manufactured products into the US which means if the USD started to fall in value countries holding the peg would have to buy US treasury bonds to hold the peg especially so with China. The beauty of this strategy is that it forced the USD down, dropped interest rates but increased the value of US treasury bonds, and broke the Chinese peg to the USD allowing US manufacturing to be able to compete globally and internally with China without tariffs with a lower value USD.

The New Zealand dollar has an average turnover of US$105 billion a day equivalent. The 10th most traded currency in the world.

The RBNZ must be very financially disciplined in its approach because simply printing cash can easily scare currency traders. Hyperinflation can occur within minutes if currency traders start unloading and dumping the NZD.

I’d also expect bailout risk to be very high under OBR if the depositor haircut were substantial, but I had expected any haircut to be relatively small: equity is burned first, then all the subordinated debt.

I’m curious what proportion of bank liabilities would be senior to regular bank deposits in any OBR scenario.

Eric, first you need to understand what is equity on a Balance Sheet. There are 2 core parts. Shareholders Paid up capital. plus Retained profits after tax forms Shareholders equity. From Retained profits after tax dividends are already paid out each year. Therefore in a bad year there is no retained profits to burn. It is already burnt each year.

Paid up capital is a historical record of the cash paid into the company. The cash is then either spent(expenses) sits on the Profit & Loss statement and therefore already burnt and not available

Or loaned out to borrowers or invested and sits as assets on the Bank’s Balance Sheet. Yes you can sell the Loan book if the property market has not collapsed and people stop paying their loan repayments through massive job losses or you can sell the various investments if it has not been impaired from say a sharemarket collapse

Therefore it makes zero sense to say “equity is burned first”. It has no meaning.

I have started researching a paper on the case for deposit insurance. As part of it, I looked at the history of its introduction in the USA. The political debate in 1933 was surprisingly sophisticated about the economics and covered nearly every point you would imagine need to be sent about the pros and cons of deposit insurance. FDR was not keen on it despite massive bank failures during his first hundred days in office.

My main concern is stopping its extension outside of the bank such as was done for finance companies. As for providing deposit insurance to banks, whatever the cap might be will not really that matter that much as politicians make every crisis worse and will always lift it.

Only a handful of finance companies was covered. More than 60 finance companies lost $6 billion of mum and dad funds. Given that the RBNZ engineered the crash of the NZ economy, decimated an entire building industry which dominoed into the loss of the development finance funding the building industry. Seems hardly fair to have been left out of a government bail out.

Do you mean senior or junior? (from context I assumed “junior” even tho they said senior)

I might try to have a closer look at what liabilities would rank behind deposits later in the week, but my sense is that the proportion would be quite small. Equity is 7-8% of bank assets and there isn’t that much subordinated debt on the balance sheets of the NZ banks. Precisely because to make OBR work the remaining (after haricut) liabiities need to be govt guaranteed, there is a pretty strong incentive on the authorities to make the existing haircut large enough that there is little risk of the guarantee costing the Crown money. It has always seemed plausible to me that a haircut of 20-30% could be imposed at the start, even if final losses ended up being, say, 10%.

Also worth bearing in mind that covered bonds in effect rank ahead of convetional deposits.

Paid up capital is the original injection of cash by shareholders. It is there to record a historical event. Retained profits is the net cash in hand from trading but is usually distributed to shareholders after tax is paid. The 7-8% you refer to is usually a cash asset or an investment on the balance sheet. Profits include non cash expenses like depreciation.

Superficially the two big groups are depositors, and, slightly indirectly the “government” Yes, the government has a significant stake in ensuring the “economy” functions, today, tomorrow, next week and next year. In fact the government is possibly a bigger stake-holder than the sum of all the depositors of all the banks

Thus. IMO, if there is any insurance to be paid, the Government should be a substantial contributor

When the Australian Government implemented its “2008 government guarantee”, insurance premiums were paid by the banks to the government out of expenses, and were not charged to clients.

Example, a bank suffers a loss for the year. Depositors panic and start withdrawing cash. The bank starts to pay out cash, and the panic continues and more demands for cash is made by depositors. Assets on the banks balance sheet declines. The bank runs out of cash because the cash is usually invested in business lending and residential lending. Share prices start to fall. Shareholders take a beating up through loss of value in their investment and the government can then buy the shares for free, recapitalise, rejuvenate and sell the bank later at a massive profit.

If depositors are guaranteed payment through a deposit insurance policy then no panic, people would be calm and leave their savings with the bank. Shareholders value loss is only temporary, next year bank is back to a profit and the shareholders regain their investment value.

a) Instead of insuring commercial bank deposits, why doesn’t the government simply sell government treasuries & bonds as “risk free” term deposits through the commercial banks & the commercial banks take a small % as a handling fee.

b) This would leave open the option of banks providing “risk free” term deposits where the banks themselves sought out the insurance arrangements. Standard term deposits would remain “risk” assets subject to default.

c) Is there a case that if deposit insurance goes ahead in NZ that it needs to match the level of insurance cover provided in Australia? Is a kiwi with an Australian bank account covered?

On a) they already do – Kiwi Bonds are retail government bonds (deliberately priced – at least when I was involved – not to sell many, but to tap the group of people who were v risk averse and wanted only govt risk. Of course, they aren’t transactions balances (EFTPOS-able etc) so only serve one of the roles of bank deposits. I”ve occasionally here made the case for the Rb to make electronic transactions balances available not just to banks but to any depositors. I still think it is a good idea (altho the RB knocked it back in a speech a few months ago). But the real problem is that demand for those products would be quite modest in normal times. People will prefer the convenience and other products banks offer, and there will still be immense pressure for a bailout when things go v wrond (which might be only once a century.

I don’t think we need to have exactly the same dep insurance scheme as Aus – altho there might be some practical advantages to doing so. There isn’t going to a public uproar if, say, Aus covered the first $250K and we only covered the first $200K.

Could banks sell ‘safe” deposits? In principle, quite easily (again so long as people were content with low returns). Simply market a product that would invest only in short-dated govt bonds or even RB settlement account balances (like some of the US money market funds). I’m wary of genuine private deposit insurance: it would work for idiosyncratic shocks, but would be put at considerable risk in a systemic global shock.

Could banks sell “Safe” deposits? Does liabilities have a value in principle? Value comes from an expected future return received by the bank holding an asset. “Safe” deposits are still a liability and the returns paid to depositors no matter how low is still a negative return. No matter how you future cashflow a negative return still gives you a negative value. If there a value in liabilities, it is usually in principle an intangible value or else only $1 is the usual offer price to sell liabilities.

I do not see OBR and deposit insurance as particularly close substitutes.

A key thrust of OBR is to keep a failed bank open and operational, thus avoiding the economic costs of closure.

Deposit insurance, by contrast, only works cleanly when a bank is closed and liquidated, because that is the mechanism for haircutting the uninsured creditors. If a bank is “too big to close”, deposit insurance per se is not very handy.

OBR also has more intrinsic flexibility than deposit insurance. Its parameters can be set at the time to fit the circumstances of the time. The terms of the deposit insurance contract are set at the outset, and are “one size fits all” – which may or may not turn out to be appropriate.

Neither scheme precommits or binds politicians, and both are thus subject to political intervention if they turn out to be inconvenient.

I am somewhat equivocal about the desirability of charging premiums and building up a fund. Whether crisis management should be funded ex ante or ex post seems moot. Maybe depositors who benefit from an implicit guarantee should pay for it in principle, but other creditors and shareholders benefit from that implicit guarantee as well.

I agree there is a quite different focus, and that the ability to keep a big bank open is something that should be given emphasis whether or not we have deposit insurance. The Bank, as you know, has historically resisted any sort of depositor protection/insurance.

As I note, I think deposit insurance provides a better chance of OBR being allowed to work – as distinct from the always more probable alternative of a straight taxpayer bailout, in lockstep with Australia.

On your second para, I don’t think that is correct, so longer as the deposit insurer can interpose itself between the deposior and the bank. Depositors can be paid out in full, while the insurance funds realisations depend on the final situation (realisation in liquidation, proceeds of a sale, or a final haircut).

Entirely agree that all parameters can be changed on the fly, but we increase the chances of a resilient model if the choices made in good times are realistic about the likely nature of the bad times political pressures.